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«November 2001 Abstract The regulations that shape the design and the operations of corporations, credit and securities markets differ vastly from ...»

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The Political Economy of Finance

Marco Pagano

CSEF, Università di Salerno, and CEPR

Paolo Volpin

London Business School

November 2001


The regulations that shape the design and the operations of corporations, credit and

securities markets differ vastly from country to country. In addition, similar regulations

are often unequally enforced in different countries. Economists still have an imperfect

understanding of why these international differences exist and of whether they tend to persist over time. However, a recent strand of research has shown that some progress on these issues can be made using the approach of the new political economy, which models regulation and its enforcement as the result of the balance of power between social and economic constituencies. In this paper we offer a first assessment of the results and potential of this approach in three fields: corporate finance, banking and securities markets.

JEL classification: G34, K22, K42.

Keywords : political economy, shareholder protection, corporate governance, bankruptcy law, credit market regulation, financial development, privatization.

Authors’ addresses: Marco Pagano, CSEF, Dipartimento di Scienze Economiche, Università di Salerno, 84084 Fisciano (SA), Italy, phone +39-081-5752508, fax +39e-mail mrpagano@tin.it. Paolo Volpin, Institute of Finance and Accounting, London Business School, Regent’s Park, London NW1 4SA, U.K., phone +44-207-2625050, e-mail: pvolpin@london.edu.

Acknowledgements : This paper was prepared for the Oxford Review of Economic Policy. We thank Franklin Allen, Chris Allsopp, Lucian Bebchuck, Eric Berglof, Tim Jenkinson, Colin Mayer, Ken Mayhem, Enrico Perotti, Oren Sussman, David Vines, David Webb, and Ivo Welch for comments and the LSE Financial Market Group for providing a congenial work environment. The research has been supported by the Italian Ministry of University and Scientific and Technological Research (MURST) and the JP Morgan Chase Research Fellowship at LBS. This paper is produced as part of a CEPR research network on Understanding Financial Architecture: Legal and Political Frameworks and Economic Efficiency, funded by the European Commission under the Training and Mobility of Researchers Programme (contract No. HPRN-CT-2000Introduction During the Great Depression, U.S. farmers oppressed by the rising burden of mortgages and by falling incomes successfully pressed their states’ legislators to pass laws for debt moratoria of farm mortgages. To further support farmers’ incomes, the Roosevelt administration devalued the dollar against gold, and abrogated all gold clauses in private debt contracts that would have otherwise triggered a wave of bankruptcies (Kroszner, 1998). While relieving distressed farmers, the policy had adverse consequences for their further access to credit: in states which enacted farm foreclosure moratorium laws, banks extended fewer farm loans and charged higher interest rates (Alston, 1984).

At the same time, on the other side of the Atlantic, the Great Depression prompted another form of political intervention. In Italy, the Fascist government launched a massive bailout of failing industrial firms and banks, and transferred the equity stakes acquired in the process to a public agency, the Istituto per la Ricostruzione Industriale (IRI). Initially designed as a temporary remedy to the crisis, IRI grew into a state-run giant holding group that dominated the Italian economy for the rest of the century, and largely replaced securities markets in financing Italian heavy industry and utilities.

Political and social turmoil was also at the root of “codetermination”, by which German employees select half of the supervisory board of large companies. This system, which had long-lasting implications for the governance of German companies, was initially introduced by a 1922 law of the Weimar Republic, in order to strike a compromise between the right and the left and achieve a minimal degree of political stability in a deeply divided country. Repealed under the Nazi regime, this arrangement was reinstated in 1951 for the Ruhr steel and coal industry by Konrad Adenauer.

Conscious of the tremendous political role played by the Ruhr industry in inter-war Germany, he felt that democracy should be combined with constraints over the use of private capital, a notion labeled as “economic democracy”. In 1976, the Codetermination Law extended equal representation of employees and shareholders to all companies with more than 2,000 employees. This arrangement, still in force in Germany, tends to shield management from the market for corporate control, by reinforcing employees’ power to resist mergers or takeovers, and diminishes control over management by fractionalizing the supervisory board and making it a potential vehicle for collusion between managers and workers (Pistor, 1999).

Political intervention in financial markets does not occur only at times of systemic crisis and social turmoil such as the Great Depression. The action of pressure groups and the career concerns of politicians often combine to produce specific political interventions in financial markets, such as nationalizations, privatizations, bailouts, vetoes to mergers and takeovers, etc. Consider the two following examples.

In 1976 six bankrupt U.S. railroad companies were nationalized with the creation of Conrail under the pressure of interest groups, formed by customers, existing claimants and employees, mostly located in the Northeast. After 11 years, Conrail was privatized.

Over this period, the U.S. government had outlays of $6.59 billion and received cash flow of $6.15 billion, implying an internal rate of return of -1.62 percent. During the period 1976-87, the major customers of the six bankrupt companies contributed over $14 million to both Democrats and Republicans and to key members of the House Energy and Commerce Committee. The benefits to Conrail’s customers amounted to over $2,774 million (Ang and Boyer, 2000).

In March 1997, Krupp made a DM 15 billion hostile bid for Thyssen AG, a corporation previously trading at DM 12 billion on the Frankfurt stock exchange. The managers of the target company rallied politicians, workers’ unions and media to its rescue, arguing that the raider intended to predate on the company and its workers to pay its shareholders. Thyssen’s campaign was successful: Krupp withdrew its offer and agreed to a management- friendly merger later on, while the stock market value of Thyssen went back to DM 12 billion (Hellwig, 2000, p. 28).

These examples illustrate that politics can interfere with financial markets in several ways. In recent years economists have developed a new approach to analyze systematically the impact of politics on the econo my, treating policy- makers as selfinterested agents responding to political incentives. This approach, known as “new political economy”, contrasts sharply with the view of policy- makers as “benevolent social planners”, which is a common hypothesis in welfare economics. The political economy approach was initially applied to macroeconomic policy- making, but is now spreading to other areas of economic policy analysis. In this paper we show how its tools and ideas can be applied to the analysis of policy interventions in financial markets, building on the first body of contributions in this field.

Which insights can we hope to get by applying the political economy approach to finance? First and foremost, we can hope to understand why often financial regulation is flawed and stifles – rather than fostering – the development of the markets to which it applies. In other words, it helps us to understand why some countries end up with “poorly designed” financial institutions or “poorly enforced” financial regulation.

Second, political economy can give us a clue as to when and why one can expect financial regulation or its enforcement to change over time. In other words, it guides us in the understanding of “financial reform” and of its feasibility. It does so by explaining which constituencies are sustaining a certain regulatory outcome, why they are currently dictating the rules, and how and why the balance of power can shift against them.

Thirdly, besides explaining how pressure groups affect regulation, political economy takes into account how in turn regulation shapes and entrenches political constituencies via its economic effects. In this sense, legal rules and economic outcomes are jointly determined, politics being the link between them. This interdependence is illustrated schematically in Figure 1.

In Table 1 we indicate various ways through which politicians can interfere with financial markets. They can either change the “rules of the game” or intervene on a case-by-case basis. In both instances, political interventions can affect the financial decisions of corporations, the working of the banking industry, or the operation of security markets. The table also indicates relevant research, where available.

Each of the next three sections of the paper deals with one of the three types of interaction between politics and finance indicated in the columns of Table 1, which can serve as a road map for the reader. The table should not, however, be taken as a rigid and exhaustive classification. For instance, specific policy interventions can durably change the rules as perceived by the generality of market participants. If the government repeatedly bails out distressed banks, bank managers may come to regard this as a systematic policy and change their attitudes towards risk-taking accordingly. Similarly, public interventions in one area may have spillovers in other areas. For example, the protection of minority shareholders can affect not only corporate financial policies but also the development of securities markets, as we shall see in the next section.

2. Politics and Corporate Finance

Politics can affect the balance of power between company “insiders” (managers and controlling shareholders) and “outsiders” (non-controlling shareholders), in keeping with Hellwig’s (2000) distinction. It does so by designing the rules intended to protect minority shareholders, as well as those that influence the contestability of corporate control. The State can have an even more direct influence over the life of companies by taking a direct stake in their ownership structure or by divesting from them, as it has happened with the recent worldwide privatization wave. In this section we analyze political interventions in all these areas.

2.1 Corporate governance Recent contributions on corporate governance show that there are large differences in the degree of investor protection across countries and that these differences are correlated with both the development of capital markets and the ownership structure of firms (La Porta, Lopez-de-Silanes, Shleifer and Vishny, 1997, 1998). The argument is that better legal protection for investors and stricter law enforcement reduce the risk of expropriation by managers and controlling shareholders. Through this channel, better legal protection and stricter enforcement enable firms to raise more external capital, and thus enhance the growth of capital markets. However, the degree of investor protection and its enforcement are not exogenous variables. They are can be altered via the political process, which in turn may respond to economic interests.

Some suggest that political choices that shape investor protection and its enforcement are simply driven by ideological factors. For example, Roe (1999) argues that the differences between the corporate governance systems in the Unites States and in Continental Europe are due to the incompatibility of the American ideology with the kind of social democracy common in European countries. According to Roe, in Europe the State is entrusted with the task of sustaining a social pact between all classes, whereby greater equality is exchanged for reduced efficiency.

Others argue that history, as summarized by the country’s legal origin, entirely determines the degree of investor protection and its enforcement within a country. La Porta, et al. (1998) show that countries whose commercial law was inspired by the French Civil code exhibit lower protection for minority shareholders and creditors and laxer law enforcement than countries with a commercial law inspired by the English common law tradition. Countries with German and Scandinavian legal origin exhibit intermediate levels of creditor and shareholder protection, and law enforcement. Since the origin of a country’s legal system is the outcome of choices made centuries ago, this “law and finance” approach (as discussed by Levine in this issue) implies that a country with French legal origin is inexorably condemned to low legal protection and lax enforcement, and therefore to financial underdevelopment. 1 Political economy models distance themselves both from the view that the degree of investor protection is driven by ideology, and from the view that it is dictated by a longrun historical imprinting of national law. They depart from the first view, since they regard political decisions as based on economic interests, not on ideology. They depart from the second approach because politicians can change laws if they choose to do it.

Political economy models can address the key issue of legal reform, on which the “law and finance” approach is mute: they can be used to analyze if and when the political balance can change and precipitate a change in the legal system and in economic outcomes. This is because in these models the State is an agent for political forces that reflect the conflicting economic interests of their constituencies. By affecting the design and enforcement of legal rules, the balance of power between constituencies affects the allocation of control rights between the company’s stakeholders – shareholders, managers, workers and possibly customers. This balance of power and the implied legislation thus shapes the objective function of companies, determining the relative weights that they place on shareholder value, employees’ welfare, etc. (Tirole, 2001).

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